Wade into the market? Or plunge?

Mutual Funds10/21/2008 12:01 AM ET
Wade into the market? Or plunge?
Evidence suggests that jumping right in with your money may generate better results than investing gradually over time. Here's why.
By Tim Middleton
With the stock market wackier than Daffy Duck, risk has risen to unprecedented levels. On Thursday, the CBOE Volatility Index ($VIX.X), which measures volatility of the prices of stock-futures contracts, soared to 80 -- the highest in its history. It's often called the fear index, and any reading over 30 is considered ominous.
That's a reason one of investing's most treasured precepts -- dollar-cost averaging, or DCA -- is finding wider and wider acceptance. You do this automatically in your 401(k), contributing a fixed amount each month, whether stocks are up or down. Thus, in a period of volatility, you spread your risk. This year, prices were down in seven of the first nine months, with extreme losses in January, June and September, not to mention the first couple of weeks of October.
But dollar-cost averaging is mind balm only. It doesn't actually reduce risk, and it doesn't increase returns.
In fact, there's evidence that investors should approach the market more aggressively. Over short periods as well as long, investing lump sums is the equal of dollar-cost averaging, except in those rare times when the market is going straight up, when lump-sum investing does better.
"At our firm, we tell clients that there is no difference," says Paul A. LaViola, the vice president of RTD Financial Advisors in Philadelphia. "However, emotionally, it can make someone feel better if they DCA when the market is going down or they are unsure about the market."
My household invests both ways, twice monthly in my wife's 403(b) and our brokerage and mutual fund accounts, and lump sums into my SEP-IRA (simplified employee pension individual retirement account) two or three times a year. My wife recently changed jobs, and we'll be rolling her old 403(b) into an IRA. It's a considerable amount, and we'll reinvest all of it. DCA is pointless, except as a crutch.
Surprising results Don't believe me? You're not alone. "I am a huge proponent of dollar-cost averaging, especially in volatile times like we are currently experiencing," says Jane M. Young of Pinnacle Financial Concepts in Colorado Springs, Colo. "I have not conducted any studies, so my opinion is based on 12 years' experience working with clients." I can understand that financial novices -- the clients of financial advisers -- are soothed by DCA. But I have done some research, and here's what I've found:
Vanguard 500 Index Fund (VFINX) over 10 years


Investments of $100 per month
Lump-sum investments of $1,200 per year
Lump-sum performance (compared with monthly investments)

Date
Price
Total portfolio value
Total portfolio value
Total portfolio +/-
Annual dollar +/-
Annual percentage +/-
Market performance
Nov. 2, 1998
$108.49
$100
$1,200
Oct. 1, 1999
$126.05
$1,267
$1,394
$128
$128
10.1%
16.2%
Oct. 2, 2000
$132.02
$2,521
$2,692
$171
$44
1.7%
2.7%
Oct. 1, 2001
$97.86
$2,922
$2,961
$39
-$132
-4.5%
-19.5%
Oct. 1, 2002
$81.87
$3,493
$3,410
-$83
-$122
-3.5%
-22.3%
Oct. 1, 2003
$97.19
$5,498
$5,390
-$108
-$25
-0.5%
11.8%
Oct. 1, 2004
$104.55
$7,130
$7,078
-$52
$56
0.8%
6.7%
Oct. 3, 2005
$111.30
$8,798
$8,763
-$36
$16
0.2%
2.3%
Oct. 2, 2006
$127.04
$11,324
$11,322
-$2
$34
0.3%
10.0%
Oct. 1, 2007
$142.83
$13,999
$14,053
$54
$56
0.4%
10.4%
Oct. 1, 2008
$82.87
$8,962
$8,880
-$82
-$136
-1.5%
-39.4%
Note: Figures may not add up because of rounding.
This shows the relative performance of two portfolios established 10 years ago in the Vanguard 500 Index Fund (VFINX), the investable form of the standard stock benchmark. One investor put in $100 on the first day of every month. The other put in $1,200 on Nov. 1 of each year.
Ten years later, we can see there is no significant difference in their returns, either in their total over the period or their annual performance. Even in this disastrous year, when the fund itself has gone down 39.4% in the past 12 months, the lump-sum investor did only 1.5% worse than the DCA investor. The greatest disparities in the overall portfolio were a lump-sum advantage of $171 in 2000 and a DCA advantage of $108 in 2003.
I shared my study with several financial advisers, and one raised two pertinent questions about my method: Why did I choose to begin in November, as opposed to some other month? And why did I choose Vanguard 500 rather than a surrogate for some other benchmark, such as small caps or foreign stocks?
To answer the first, I wanted 10 full years of data, as of the most recent possible date. Beginning in November 1998 allows both investors to make identical annual contributions. Further, I chose Vanguard 500 because this is the market. Most investors have the bulk of their equity assets in domestic big caps.
The adviser didn't ask why I chose 10 years as my study period, but I'll tell you anyway: It reflects roughly five years each of bull and bear markets. In fact, the current bear market and that of 2000-02 are both monsters, marked by declines of more than 40% -- the only time besides 1973-74 this has happened since the 1930s.
If anything, such extreme downward volatility should have favored the DCA investor. But it didn't.
Continued: What advisers say
What advisers say One adviser with whom I shared my study said it was unconvincing because the lump-sum contributions each November themselves represent DCA, only annually instead of monthly. More realistic, he said, is the lump sum that arrives possibly only once in a lifetime, such as an inheritance or 401(k) rollover.
"Accordingly, for most of my clients I say, 'Why not just invest the lump sum and be done with it?' Most people will take this approach," says Warren J. McIntyre of VisionQuest Financial Planning in Troy, Mich. "However, for someone skittish about the market by nature, especially during a volatile time like now -- I think DCA is a great strategy from a psychological standpoint."
Fair enough. Every investor needs to remain in his own comfort zone. But research from DCA critics has demonstrated that lump sums aren't just the equal of DCA but are instead superior to it.
Dimensional Fund Advisors, a firm that runs sophisticated index funds that are sold only through financial advisers it trains in-house, did a study in 2004 called "To Wade or Plunge." In it, the firm studied four types of portfolios -- domestic equity, domestic balanced, global equity and global balanced -- over periods dating to 1970 for foreign securities and to 1927 for domestic stocks and bonds. In the trials, one portfolio invested on the first day of each year, while the other invested quarterly.
"For the domestic portfolios during the 1927-2003 period, plunging beat wading in about two-thirds of the trials. The average one-year excess return of plunging over wading was nearly 6% for the domestic equity portfolio and about 4% for the domestic balanced portfolio," the study says.
"For global and domestic portfolios during the 1970-2003 period, plunging again beat wading in about two-thirds of the trials. The average excess returns for plunging over wading were about 4.5% for global equity, 3% for global balanced, 5% for domestic equity and 3.4% for domestic balanced."
Despite such evidence, most of the two dozen or so financial advisers I polled last week are strong supporters of DCA. I don't blame them. What if they had recommended that a new client take the plunge on Oct. 1? By Oct. 10, the Vanguard 500 fund was down 22.5%. The client would have been gone, and everyone he met for the rest of his life would hear what a lousy adviser that poor sap turned out to be.
But if I had invested a bundle on Oct. 1, I would have gritted my teeth and held on. By Oct. 13, my loss was only 13.5%. Ten years from now I'll be lucky if I can remember what happened in those 10 days. And I would be sitting on a nice wad of money.
So take your choice. You'll probably make more money investing lump sums, but there's a chance you won't. You make choices like this all the time; you can break your neck riding a bike. TV's Monk -- whose theme song is "It's a Jungle Out There" -- doesn't strike me as the lump-sum type, but I suspect most of us are.
Meet Tim Middleton at The Money Show MSN Money's Tim Middleton will be among more than 50 investing experts gathered in the nation's capital Nov. 6-8 for the fourth annual Money Show Washington, D.C. Just days after the election, this elite group will present more than 170 free workshops to help you prepare for changes in the political landscape. Admission is free for MSN Money users.
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At the time of publication, Tim Middleton didn't own any securities mentioned in this article.

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